Saturday, January 31, 2015

The Earnings Trend Is Again Apple’s Friend

On Tuesday, January 27th, Apple announced December quarter results with record revenue of $74.599 billion, record net income of $18.024 billion and record earnings per share of $3.06. Beyond those superlatives, Apple also set a global record for quarterly net income of any publicly-traded enterprise in history. The depth, spread and scope of Apple’s December quarter success caught even the most bullish Wall Street analysts by surprise. 

The good news for Apple shareholders is the company’s December quarter results are not a crescendo but merely the first fiscal episode in a new epoch of outsized enterprise success.

The Earnings Trend Is Again Apple’s Friend
The graphs below illustrate the dramatic change in the company’s revenue and earnings trends delivered in the December quarter. 
Against a backdrop of foreign exchange headwinds, Apple’s recognized revenue on a sequential basis rocketed higher by 77.1% in the period. On a year-over-year basis, revenue rose 29.53% The December quarter delivered the highest rate of year-over-year revenue growth since the March quarter of FY2012, nearly three years ago. On  a sequential basis, the rate of revenue growth was the fastest rate of growth in the study period of just over six fiscal years or twenty five fiscal quarters. 
On a year-over-year basis, Apple’s 47.83% rise in earnings per share was the fastest rate of growth since the March quarter of FY2012 and on a sequential basis, the fastest rate of growth in the twenty five fiscal quarters under study. Aided by the ongoing $90 billion share repurchase program, Apple’s record net income of $18.024 billion translated into earnings per share of $3.06 in the December quarter. In the period net income rose 37.88%.

Apple’s Fully Diluted Share Count
The graphs below illustrate the significant drop in the reported fully diluted share count. 
During the December quarter conference call with analysts, Apple CFO Luka Maestri stated the company had completed $73 billion of the planned share repurchases under the $90 billion share repurchase program. The Form 10-Q for the quarter puts the amount already invested in share repurchases at $72.90 billion comprised of both accelerated share repurchase programs and open market share repurchases.
To further illustrate the dramatic drop in fully diluted share count, I have charted the percentage changes in the fully diluted share count on a sequential and year-over-year basis. From the peak in FQ4 2012, on a split-adjusted basis, the fully diluted share count has fallen 12.84% through the December quarter.

Because Apple averages the number of fully diluted shares in each quarterly reporting period, any and all repurchases in a quarter this calendar year will have a residual and beneficial impact on earning per share in the corresponding quarter in 2016. Although there is much speculation Apple will announce an expansion of the current repurchase program in April, the repurchases are currently scheduled to be completed by the end of CY2015.

The Apple iPhone Echo Effect
In the December quarter Apple sold 74.468 million iPhone units. On a year-over-year basis, the 45.94% unit sales growth rate represents the fastest rate of growth since FQ4 2012 and on a sequential basis, the 89.62% rate of unit sales growth is the highest since the December quarter three years ago. 

The graph below illustrates Apple iPhone unit sales over the past twenty five fiscal quarters.
In terms of unit sales volume growth, the 23.443 million unit sales increase on a year-over-year basis was the highest in the product line’s history. On a sequential basis, iPhone unit sales catapulted higher by 35.196 million units. This is also a new record for unit sales growth when measured on a sequential basis. 

Apple’s previous unit sales growth records on a year-over-year basis for the iPhone line were set back in the era in which the iPhone 4 series handsets delivered extraordinarily high unit sales growth results. That series of handsets were the first iPhones to deploy the so-called Retina display. Beginning with the current iPhone 6 handsets, Apple has introduced larger-screen handsets. This is the most conspicuous enhancement to the product line since the introduction of the Retina display. 

The new trends that have emerged following the release of the larger-screen iPhones suggest very strong revenue, net income and earnings per share growth over the next several quarters. In my view, the December quarter results evidence what I call an “Apple iPhone echo effect” which will benefit unit sales growth through the March quarter of FY2016. 

In a response to a question from Morgan Stanley analyst Katy Huberty during the December quarter conference call with analysts, Apple CEO Tim Cook noted the iPhone 6 handsets generated the highest “Android-switcher rate” in at least the past three new model launches. He went on to say the new handsets are appealing to new iPhone customers as well as customers purchasing their first smartphones. 

In response to a question from JPMorgan analyst Rod Hall, Mr. Cook stated only a “small fraction” of the installed base of current iPhone owners participated in the record sales of iPhones in the December quarter. Apple’s CEO expects Android switchers, current iPhone customers upgrading to new handsets and, particularly outside the United States, consumers purchasing their first smartphone to select the Apple iPhone in large numbers.

Last model year Apple debuted 64-bit mobile computing with the introduction of the iPhone 5s. While the jump to 64-bit mobile computing will strengthen the foundation of Apple’s iOS platform, for consumers it was not a conspicuous enhancement to the product line. The larger-screen iPhones provide the most conspicuous enhancement to the customer experience since the iPhone 4 series handsets. Similar to the way iPhone unit sales ballooned during the era of the iPhone 4 series handsets, the iPhone 6 series handsets will build on the installed base of existing iPhone owners through at least the March quarter of FY2016. The iPhone 6 handsets will continue to draw customers migrating from Android while appealing to consumers purchasing a smartphone for the first time.

Apple’s Deferred Revenue Balances
In the December quarter Apple added on a sequential basis $945 million to the company’s deferred revenue total. The year-over-year rise was $1.039 billion. At the end of the quarter Apple had $12.467 billion in current and non-current deferred revenue on the balance sheet. 
While the pace of growth in the company’s deferred revenue total has recently moderated on a year-over-year basis, much faster rates of revenue growth this fiscal year may deliver rising deferred revenue balances each quarter of the current fiscal year. In other words, more revenue may be deferred in each quarter this fiscal year than is recognized from deferred revenue in prior periods. The fact that Apple defers up to $25 in revenue per iOS device sold and $40 in revenue per Macintosh sold to future periods will provide a slight boost to revenue growth as early as the second half of FY2016.

The Apple Watch
In his prepared remarks at the start of the December quarter conference call with analysts, Mr. Cook announced the Apple Watch will commence shipments in April. About the only things the Apple Watch has in common with a conventional watch is that it will tell time and will be positioned on the wrist. The wrist is about the most comfortable place on the human body for a wearable device and wrist-based timepieces have been in use for generations. Yet the Apple Watch is more than a timepiece. It’s a wrist-based computing and communications device. 

As journalists and analysts begin to look beyond the context of the form and have more information concerning the new product line’s features and functions, I expect estimates for shipments and consumer sell-through in the first six months from release to rise significantly.

Onward And Upward…
The December quarter was the first episode in a new epoch of growth for Apple. Following the release of December quarter results, the consensus revenue estimate for FY2015 has risen to $223.48 billion and the consensus earnings per share estimate is now at $8.49. At Apple’s closing price on Friday of $117.16, the shares are trading at only 13.80 times anticipated FY2015 earnings per share. 

At this time I am raising my FY2015 revenue target to $235 billion. I expect net income as a percentage of revenue to hover in the range of 23% for the fiscal year. Prospects are strong for a dividend boost by Apple in tandem with the announcement of an enhanced share repurchase program. With $17 billion under the current repurchase program to be invested by the end of the calendar year, the “Apple iPhone echo effect” propelling the product line’s unit sales and the Apple Watch set for release at the start of the June quarter, Apple’s new epoch of growth will write its own chapter in enterprise history. The earnings trend is again Apple's friend.

Disclosure: The author is long Apple shares

Robert Paul Leitao